Design and Estimation of Multi-Currency Quadratic Models

To simultaneously account for the properties of interest-rate term structure and foreign exchange rates within an arbitrage-free framework, we propose a multi-currency quadratic model with an (m+n) factor structure. The m factors model the term structure of interest rates in both countries. The n factors capture the portion of the exchange rate movement that is independent of the term structure of either country. We estimate a series of multi-currency quadratic models using U.S. and Japanese LIBOR and swap rates and the exchange rate between the two countries